Chasing hot mutual funds is a losing proposition

The returns earned by mutual funds may not be the same as those earned by the investors who buy them. A recent study by a university professor and two public foundation researchers indicates that mutual fund investors may have earned much less than the returns reported by the funds. The study, recently reported in Money magazine, showed that money usually pours into hot mutual funds after they have earned big profits. The investors who thought they were hopping onto a gravy train often found that they made little money, or, even worse, lost it. Charles Trzcinka, a former University of Buffalo professor who now teaches at Indiana University, called the disparity between fund returns and investor returns “shocking and tragic.”

The study did not question the reporting of returns by the funds. That process is rigorous and generally honest, with funds reporting returns both quarterly and for the calendar or fiscal year. But the average investor does not put all of her money into a mutual fund on Jan. 1 and sell it on the following Dec. 31. Money is invested at different times throughout the year. The statistics on many funds showed that big inflows of new money followed quarters or years when the individual funds soared. The investors who were hurt the most were those who put their money into the once-flashy technology and high growth funds and fund families. For instance, the average annual reported gain by Janus for its stock funds from 1998 through 2001 was 5%. But the study showed that the average investor’s timing in buying funds during this period was off, causing him to lose 11.1% per year.

Chasing hot funds is almost always a bad idea, says the Vanguard Group, a Pennsylvania-based mutual fund company. It notes that technology mutual funds rose an average of 135% in 1999. That performance was followed by a record inflow of $34 billion into tech funds during the first quarter of 2000. Unfortunately, that money came in just as the science and technology stock sector began to sink. From March 2000 through this year, the sector had declined by almost 75%, taking new investors in those funds with it.

Hot money hurts investors in several ways. First, sectors or asset classes that earn above average returns in one period often provide substandard returns subsequently. Second, fund managers who are suddenly confronted with huge amounts of new cash to invest cannot repeat their previous eye-popping performance. They are rushed to put the cash to work, and often can’t find enough investments of the type they usually use at the right price in order to keep their funds ahead of the pack.